What is Sharpe Ratio?
The Sharpe Ratio, developed by Nobel laureate William Sharpe in 1966, measures risk-adjusted return by calculating how much excess return an investment generates per unit of volatility. It answers a fundamental question: Is the return worth the risk taken to achieve it? In crypto and traditional finance alike, the Sharpe Ratio remains the most widely used metric for comparing investment performance across different risk profiles.
The formula is elegantly simple: Sharpe Ratio = (Portfolio Return - Risk-Free Rate) / Standard Deviation of Returns. A higher Sharpe Ratio indicates better risk-adjusted performance. A ratio above 1.0 is generally considered acceptable, above 2.0 is very good, and above 3.0 is excellent—though sustained Sharpe Ratios above 2.0 are rare in liquid markets.
How Sharpe Ratio Works
Calculation Components:| Component | Definition | Crypto Context |
|---|---|---|
| Portfolio Return | Total return over period | Including yield, not just price |
| Risk-Free Rate | Return on "safe" assets | Often 0% or stablecoin yield |
| Standard Deviation | Volatility of returns | Daily, weekly, or monthly |
- < 0: Negative excess returns (underperforming risk-free)
- 0-1.0: Acceptable but modest risk-adjusted returns
- 1.0-2.0: Good risk-adjusted performance
- 2.0-3.0: Very good, often found in skilled strategies
- > 3.0: Excellent, but verify sustainability
Annualized Sharpe = Daily Sharpe × √252 (trading days)
Longer measurement periods provide more reliable estimates but may miss regime changes.
Limitations:- Assumes normal distribution of returns (crypto is fat-tailed)
- Penalizes upside volatility equally with downside
- Can be gamed through leverage or illiquid pricing
- Historical Sharpe may not predict future performance
Practical Examples
Consider two crypto yield strategies:
Strategy A: 25% annual return with 40% volatilitySharpe = (25% - 5%) / 40% = 0.50
Strategy B: 15% annual return with 12% volatilitySharpe = (15% - 5%) / 12% = 0.83
Despite lower absolute returns, Strategy B delivers superior risk-adjusted performance. An allocator could leverage Strategy B to match Strategy A's returns while taking less risk, or achieve higher returns at similar risk levels.
In practice, top-tier crypto hedge funds target Sharpe Ratios between 1.5-2.5. Market-neutral strategies often achieve higher Sharpes through consistent, lower-volatility returns rather than outsized gains. The Barclayhedge CTA Index historically shows Sharpe Ratios around 0.3-0.5, while the best systematic crypto strategies can exceed 2.0.
Why It Matters for Allocators
Sharpe Ratio is the cornerstone of professional portfolio construction:
Strategy Comparison:- Compare [delta-neutral](/insights/glossary/delta-neutral) strategies across vaults
- Evaluate whether higher yields justify increased volatility
- Identify strategies with sustainable alpha vs. lucky runs
- Optimize allocation weights based on risk-adjusted returns
- Combine uncorrelated strategies to improve portfolio Sharpe
- Set realistic return expectations for given risk budgets
- Sharpe > 3.0 sustained over years (likely reporting issues)
- Sharpe calculated on illiquid or mark-to-model assets
- Short track records with high Sharpes (insufficient data)
- Inconsistent Sharpe methodology across managers
- Distinguish skill from leverage and market beta
- Measure [benchmark](/insights/glossary/benchmark-index) outperformance properly
- Understand true [NAV](/insights/glossary/nav) appreciation sources
- Allocate capital based on risk-adjusted contribution
- Size positions to equalize risk rather than capital
- Monitor Sharpe decay as strategies scale
The Sharpe Ratio transforms absolute returns into comparable, risk-normalized metrics—essential when evaluating diverse crypto strategies from yield farming to systematic trading.
Fensory calculates and displays Sharpe Ratios for all listed vaults using standardized methodology, enabling direct comparison across strategies and helping allocators build optimally diversified portfolios.